Several news stories about pensions have crossed my desk in recent days, each of which made me realize how poorly the vast majority of individuals – even many highly educated individuals – understand financial risk. It might not be so surprising if this lack of understanding was limited to the “general population.” What is more surprising is how often highly educated financial market participants and regulators exhibit their ignorance of fundamental finance principles. Unfortunately, these misunderstandings can have real consequences.

“Rauh insists that when projecting pension fund returns, the interest rate for 10-year Treasuries must be used. Pensions do not allocate their assets 100 percent into Treasuries, though.”

This is an example where you can take two true statements, put them side-by-side, and end up with a false implication. It is true that Joshua Rauh and his co-author Robert Novy-Marx use a Treasury rate to discount pension liabilities. It is also true that pensions do not allocate their assets 100 percent into Treasuries. The problem is that the second statement is 100% irrelevant to the first!

As any individual who receives a passing grade in my finance courses should be able to explain, the appropriate discount rate to use when computing the present value of a stream of cash flows depends on the riskiness (generally defined as the correlation of those cash flows with the market) of those cash flows. In the context of pensions, the discount rate depends on the risk of the pension payments to beneficiaries. In many states – such as Illinois and California – there are strong constitutional protections in place that make already-accrued benefits risk free. Thus, what Novy-Marx and Rauh do in their research is to apply basic finance principles to come up with a more accurate measure of pension liabilities than what one gets from using official government statistics. Cate Long fell into the same trap that so many others have – including the Government Accounting Standards Board (about which I have previously blogged here and here) – of thinking that the right discount rate is a function of the risk fo the assets, instead of the risk of the liabilities. As a result, she – like GASB – completely ignores an enormous implicit put option that is being dumped onto taxpayers. Her piece also contained other problems that are discussed Josh Rauh’s response.

A second example comes from the ongoing debate about pension funding policy for corporate pensions. In January, the American Benefits Council put out a press release (which you can read here) basically arguing for “relief” from fully funding pensions (“funding relief” is a political euphemism for not meeting the required funding obligations.) At the core of the American Benefits Council’s case is that interest rates change, and that the result is that pension liabilities look “artificially high” when interest rates are “artificially low.” What this argument ignores, however, is that any firm could choose – if they so desired – to nearly completely immunize themselves against interest rate fluctuations by investing in a fixed income portfolio that has the same interest rate sensitivity as do the pension liabilities. Firms choose not to do this for a variety of reasons, but it is a choice. Some firms – most recently, Ford Motor Company – appear to understand this. Most other companies choose to expose themselves to risk in the pursuit of higher returns. That is their right and their choice, but they should not expect a back-door government bail-out in the form of funding relief when the risk then materializes.

In both of these examples – the choice of discount rates and the choice of asset allocation – the common element is a lack of understanding of risk, how to measure it, and how to manage it. Unfortunately, such a misunderstanding has real economic consequences, and it always seems to be the taxpayer who ends up paying for it.